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Thrift Banks: Transition in a Changing Regulatory Environment

The Dodd-Frank Act is imposing sweeping changes to the financial services industry, which will materially impact thrift banks’ risk management practices, infrastructure and governance as they transition to new regulatory examiners. Consolidation is likely among all depository institutions, so thrift executives should plan for and manage gaps in their business practices by investigating personnel capability, expanding markets and products, cutting costs and lowering enterprise risk.

Legislative and regulatory actions didn’t start with Dodd-Frank, it was a culmination of 20 years’ effort to apply consistent financial institution regulatory oversight, erode thrifts’ preemption and broaden assets beyond residential mortgages to reduce risk and improve profitability.

In 1985, there were 3,274 thrifts versus 1,121 today. By January 2007, before the residential mortgage bubble burst, the commercial banking industry already held more than twice the volume of residential mortgages than thrift banks. These industry dynamics, in conjunction with the qualified thrift lender (QTL) test and other restrictions, should motivate thrifts to consider adjustments in risk culture and operations, including conversion to a bank charter.

The federal banking agencies’ Joint Implementation Plan (issued in early 2011) states that the Federal Reserve will apply similar condition, performance and activity assessment standards to SLHCs as bank holding companies. Prior to Dodd-Frank, SLHCs did not have prescriptive capital requirements and were not always required to be a “source of strength” to their subsidiary thrift. However, under Regulation Y, all bank holding companies with more than $500 million of assets have consolidated capital and “source of strength” requirements. One of the most important advantages of the federal thrift charter has been preemption of federal law under the Home Owners’ Loan Act – covering state fees, disclosure, licensing, inspection and other restrictions on lending activities. Dodd-Frank eliminates the federal thrift preemption under §1044.

The Act also merged the Office of Thrift Supervision (OTS) with the Office of the Comptroller of the Currency (OCC), effective July 21, 2011 – directing the OCC to now exercise all federal thrift rulemaking authority not already granted to the Federal Reserve. As a result, the OCC may change existing thrift regulations and seek consistency wherever possible. Thrifts, particularly federal thrifts, should prepare for changes in regulatory approach, which may involve more prescriptive expectations for risk management processes, control structures, monitoring and reporting.

A Realistic Assessment

To prepare for the shifting oversight requirements, thrift organizations should consider a realistic assessment of compliance, governance, risk, control, operational and reporting processes. Examples include: a review of key risk indicators, key performance indicators, evaluating the thrift’s risk appetite, credit metrics, limits and benchmarks, and residential mortgage servicing and foreclosure processes. Also, thrift institutions must ensure they have effective compliance infrastructure, governance, and self assessments. Failure to identify and manage various facets of fair lending activity, the bank secrecy / anti-money laundering regulations or the Flood Disaster Protection Act could result in enforcement actions and civil money penalties, as well as damaged reputations.

A sound enterprise risk framework that addresses identification, measurement, monitoring and reporting is important, particularly related to credit, liquidity and interest rate risk. Operational risk has taken on added emphasis in the areas of vendor management, model risk, new product or service development and data security.

Other areas that will receive renewed regulatory oversight include:

• Credit underwriting metrics
• Compensation arrangements
• Concentration monitoring
• Strategic, capital and contingency plans
• Management information systems

Bank Charter Conversion Considerations

Dodd-Frank eliminated some key advantages of the federal thrift charter, but continued constraints such as the QTL. The Act also broadened the definition of a covered transaction with an affiliate, strengthened the requirements for interstate acquisitions and expanded standards for residential mortgage originations. SLHCs had already received historic valuation discounts for their stock shares compared to bank holding companies prior to the Act. Conversion to bank charter could also allow thrifts to expand markets and products, spread risk of loss and improve stock share valuation. In light of the changing regulatory guidance and residential mortgage market, thrifts should consider converting to a national or state bank charter. In the last 10 years, more than 120 thrifts converted to commercial banks, including Capital One Bank, FSB, Webster Bank and First Niagara Bank.

A thrift considering a national bank charter should implement effective enterprise management processes and also evaluate the following:

• Capital structure based on Dodd-Frank changes
• Director qualification issues
• OCC conditions of approval that address capital and liquidity minimums
• Source of strength regulatory directives for the holding company or ownership group
• Interstate operations and future branching
• Adequacy of present business plan
• Other safety and soundness directives that may be applied by the OCC

Conclusion

The changing regulatory environment has altered the landscape for thrift organizations. New regulatory oversight and expectations now require thrifts to re-evaluate current methods of operation. Conversion to a federal or state bank charter adds other considerations to assess. Investigating best practices that meet Federal Reserve, FDIC and OCC expectations is critical for the future success of an existing thrift or one considering conversion to a bank charter. A thoughtful assessment of the current culture and ongoing strategic planning will promote long-term stability and profitability for thrifts during challenging times.

Michael Bazata, Senior Director, and David Skala, Director, are co-authors of this story.